2Q 2023 Quarterly Investment Forum

For US regional banks, funding cost pressures are the focus of investors. Those have been driving negative revisions and are likely to continue doing so.

Deposit betas are likely to rise, with quantitative tightening adding to pressures on deposits. Credit costs are rising, loan growth is slowing, funding stresses have emerged, fee income trends are mixed, and buybacks are curtailed. There is an elevated risk of further stresses to regional banks. Loan to deposit ratios have risen a lot, and firms also may have to realize losses to meet outflows.

Tougher regulatory requirements are going to be pushed upon the regionals, so they will need to build capital, hold more liquid assets, and have more long-term debt on the funding side. In our view this may lead to 200 to 300 basis points of compression in return on equity for regionals, which could be more severe if cyclical factors take a turn for the worse.

The slowdown we have seen in the economy is also evident in real estate. But since it has been a ‘slow’ slowdown, that has bought us some time. In private real estate, the numbers are not as bad as some might think. Rents are growing in all sectors except office, which is really struggling. Vacancies are up in all sectors, and while there has been some slowdown in demand, elevated supply is the real problem (excluding retail).

In private real estate, prices are down about 6 to 7% over the past year – far better than publicly traded REITs. Roughly half of that is offset by income. But the pain has arrived in the past two quarters, and there is more to come in 2023 – particularly in offices.

Pension funds and other institutions already have a decent amount of this sector in their portfolios. We do not believe office conversions to multifamily will be a big theme. There are a lot of risks in execution, since you need municipality cooperation, and these conversions can be difficult and expensive.

There are huge opportunities for private funds, which can afford to be picky. We think there will be attractive options in industrials and residentials, as well as from diversifying into niche centers like cold storage. We are also really interested in partnering with tech-enabled companies – start-ups that have technology but not capital – so that we can enhance our capabilities in this area.

Loans are an inherently risk-averse asset class. They are senior secured and floating rate, so they hedge against rising rate environments and have had particularly good relative performance over the past year. Typically, this lower-volatility, diversifying, income-generating asset delivers a positive annual total return – in the past 20 years, it has only been down in three (2008, 2015, and 2022).

The asset class also has an asymmetric risk profile – it is about what you don’t own as much as what you do. The trailing default rate is about 2.7%, and one big name accounts for 40 basis points.

Presently, the credit premium in loans is about 130 basis points wide to high yield, so there may be some relative value there, more potential return in addition to the capital structure benefits. Banks were fine with being disintermediated in the early stages of the syndicated loan market, and happy to trade loans. Since 2016, private equity capital market activities have caused a convergence between syndicated loans and private debt. As private markets scale, the banks are trying to figure out where lost revenues will be made up. They likely won’t be able to do it fully through lending to the private lending community. A lot of money is also moving into direct lending, which will be a challenge for banks and syndicated managers who now need to step up on the private side.

We focus on making loans to family/founder-owned companies at the lower end of the middle market, and are excited by the opportunity set ahead of us and tailwinds for our business. The dynamics we are seeing these days, with regional banks having to pull back from lending, really reminds me of those supply/demand imbalances that accelerated growth in private credit from 2010 onwards.

We are seeing a tightening in credit, but not yet a credit crunch. And that is important because in aggregate the markets served by regional and mid-sized banks are huge. US middle-market corporates on a standalone basis would be the third-largest economy in the world, and much of that cohort is served by those lenders.

So the credit crunch is less severe compared to the GFC, and the imbalance is being created in a more fragmented market. Most private credit funds are not organized to capitalize on this opportunity set, because they have been moving towards larger deals. A small pullback from regionals creates thousands of opportunities to lend to smaller companies that need to grow or refinance debt. You need the right network to capture that deal flow, with strong connectivity, as well as the right skillset and mandate. Family/founder-owned companies tend to be a bit different to private equity-owned companies. When you negotiate, the dynamic is also very different, as these deals tend to be less heavily competed and more lender-friendly.